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Fixed income

CoCos: the evolution of a market

We chart the growth of CoCos from the aftermath of the global financial crisis to today.

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We chart the growth of CoCos from the aftermath of the global financial crisis to today.

High yields are hard to find without taking undue risk in today’s world.

But the Contingent Capital (CoCo) market currently offers yields in excess of those available on traditional high yield bonds, and with the backing of investment grade issuers. In addition, the returns it generates tend to have a low correlation with other fixed income asset classes – and it is relatively liquid.

This all sounds a little too good to be true, but it is not. So how can this be?

It is instructive to look at the situation before the global financial crisis. Light-touch regulation had allowed banks’ balance sheets to swell in size, with relatively slim levels of capital supporting them. The true riskiness of the assets was under-estimated, and when the sub-prime crisis struck the US, the reverberations caused the failure of several banks in Europe.

Regulators reacted swiftly and aggressively. Banks were ordered to hold far more capital, and measures were put in place to ensure that a failing bank would not have to rely on its government for a bailout again. Risk-measurement systems were also tightened, making the holding of certain types of assets, such as collateralised debt obligations, economically unviable.

The effect was dramatic. European banks raised €600bn of fresh equity through rights issues, while they shrunk their balance sheets at the same time as retaining as much profit as they could. This increased equity levels meaningfully, but the process was slow and bore an economic cost. There was a drive to develop a new form of capital, which would satisfy regulators in its ability to absorb losses under duress – but would be cheaper and quicker to issue than equity. So, with regulatory blessing, the AT1, or Additional Tier 1 CoCo, was born.

IMPROVING CAPITAL RATIOS

AT1s fell between two stools: the bonds can be converted into equity, or be written down, under extreme stress; as a result, they did not find their way into mainstream bond indices. Unsurprisingly, they did not find their way into equity indices either, so the traditional buyer base did not invest in the securities. This meant buyers had to be tempted in with attractive yields; the first such bonds were issued with coupons above 8%.

Time has mellowed investors, and yields have dropped, but the complexity of the product and its non-index status has still left some AT1s yielding in excess of 6%, with three times the spread of the same issuers’ Tier 2 bonds1.

Importantly, the likelihood of AT1s actually being converted is very low, in our view. Capital ratios have increased hugely across Europe, while balance sheets have been de-risked. As an example of this, the UK ran a stress test of its banks in 2016, where losses for the system were five times as high as during the financial crisis, and yet the weakest of the banks, RBS, ended this stress test with a capital ratio higher than that with which HBOS entered the crisis. This is a meaningful improvement in solvency.

Regulation has also been clarified over the last two years. The levels at which AT1 coupons need to be passed were vague until the first quarter of 2016; however, these have now been made clear. Banks themselves are also keen to protect their CoCos, as the capital is much cheaper than equity. Unicredit, for example, chose to raise €13bn of fresh equity to recapitalise rather than being forced to trigger its CoCos. The latter route would have closed the market in the cheapest form of Tier 1 capital to the bank.

HOUSEHOLD NAMES

With regulators and companies both acting in favour of the AT1 holder, and with the regulation surrounding the coupons now determined, we feel the asset class is ripe for fresh investment.

To date there are about US$150bn of the securities in issuance from some of the world’s biggest and best-known banks. The largest issuance has come from HSBC, UBS, Barclays and Credit Suisse – all household names. The estimate is that by the time the banks have issued all the CoCos they are able to, the market will have increased to about US$250bn. Demand also appears to be growing: a recent issuance by Julius Baer was initially thirty times oversubscribed.

Liquidity in the asset class is high – probably the best in the entire credit market – and certainly vastly better than in the highyield market.

So what is the downside? There are certainly a number of tank traps out there. When a bank fails, it does not tend to do so in a smooth fashion, allowing for the gradual erosion of capital levels. It fails properly, overnight. Bank failures are usually preceded by a ‘run,’ where deposits are withdrawn and the bank becomes illiquid. This, of itself, should not lead to a failure, as central banks have made liquidity available to the system since the crisis. But it is a symptom usually of a deeper malaise: a capital problem.

Once confidence in a bank has gone, nothing can save it. Recently in Spain, Banco Popular Español was struggling under the weight of historic bad debts; the requirement to write them down to realistic levels was too much for its capital base. A run started, and the regulator intervened. The bank’s equity, AT1 and Tier 2 bonds were all written off, before the remaining business was sold to Santander.

This case teaches two important lessons. First, a weak bank is dangerous and should be avoided; and second, in the end, equity, AT1 and Tier 2 face the same risk in extremis – that of total loss.

PORTFOLIO CONSTRUCTION

With the above in mind, the process used to construct a portfolio of CoCos is key. Within the Old Mutual Financials Contingent Capital Fund, there are three separate stages we apply in order to weed out those banks with weakness in their balance sheets andcapital structures.

First, there is a creditworthiness test, based on the principles that would allow a fund to invest in a corporate bond

Next, there are two CoCo-specific tests which measure the buffer between the current position and when coupons would have to be turned off

For example, these tests have in the last year ruled out Banco Popular (never held in the portfolio) and Deutsche Bank.

Our fund offers a very pure exposure to the asset class, with at least 75% invested in CoCos at all times, and daily liquidity. The yield on the fund is currently about 6%; it can also offer a degree of capital appreciation from new issue premia and spread-tightening. It is expected that the vast majority of returns will derive from the fund’s yield, though.

We believe these characteristics will prove highly attractive for yield-seeking investors.

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